Dialogue with NGC Cai Yan: From Mechanism Innovation to Value Accumulation, Analyzing the Development Logic of DeFi Products

This article is an original piece by Chain Catcher, authored by Wang Dashu.

DeFi has always been a hot topic in the industry. As this sector matures, it has begun to be segmented by the market. In addition to the commonly mentioned lending and DEX, some micro-innovative tools are gradually being amplified, such as insurance protocols and fixed-rate protocols. The value and risks of these segmented areas have also attracted considerable attention from the market.

NGC Capital has long been an important investment institution in the DeFi field. Its Managing Director, Cai Yan, has many observations, experiences, and unique insights regarding the overall landscape and details of the DeFi sector. This time, Chain Catcher engaged in an in-depth exchange and discussion with Cai Yan on these issues, hoping her interpretations will inspire you.

Chain Catcher: Regarding the essence of DeFi, some believe that Bitcoin is the true DeFi, and that the current DeFi protocols are merely financial experiments. How do you understand this viewpoint? What should a true DeFi product look like?

Cai Yan: The underlying logic of this viewpoint, in my understanding, is that only Bitcoin is the unique digital currency that has gained recognition from traditional institutions outside the crypto space. In comparison, the DeFi protocols currently being played within the space are indeed just financial experiments.

As for what constitutes a true DeFi product, I believe Uniswap is a very typical representative and a groundbreaking product. Firstly, it is a completely open product, with no barriers to participation for anyone or any project. Secondly, it features decentralized power, meaning the team or multi-signature parties cannot modify existing contracts and parameters.

Most importantly, it is the team. The team is very inclusive and can listen to various suggestions from the community, and their development capabilities are also top-notch.

In summary, a true DeFi product must first ensure sufficient security and stability. If it can innovate on functionalities based on this, that would be great. Products like Uniswap that gradually become the infrastructure of DeFi are more of a rare occurrence.

Chain Catcher: Fixed-rate protocols have received considerable attention, but upon observation, we find that most protocols still resemble traditional financial CDOs (Collateralized Debt Obligations), which carry high risks. How do you understand the value and risks of this business?

Cai Yan: Indeed, some fixed-rate protocols operate similarly to CDOs, binding a bond behind them. However, not all fixed-rate protocols follow this model. A primary representative of such CDO-like projects is 88mph, which is linked to lending protocols like Aave and Compound, creating fixed-rate and floating-rate bonds based on this.

For example, APWine, which is also linked to Aave, issues futures yield tokens to lock in your earnings; Notional itself operates a lending market and has developed a fixed-rate protocol on that basis.

Non-CDO models like Horizon resemble a rate aggregator, where users need to auction to generate more suitable target yields; projects like Saffron and BarnBridge define different yield rates through risk grading. Overall, there is quite a bit of innovation.

In terms of value, one aspect is innovation, and the other is the potential for imagination. In traditional finance, businesses like banks that create fixed-income securities or rating agencies that provide risk grading are quite large and profitable. Correspondingly, in DeFi, this grants similar businesses significant imaginative potential. Especially since there aren't many mature products in fixed-rate protocols yet, various micro-innovative attempts become very interesting.

On the risk side, it depends on the specific models. For instance, fixed-rate protocols linked to lending protocols like Aave and Compound could be damaged if these lending protocols are attacked.

Similarly, if one operates a lending market, it may require strong development capabilities. Additionally, if the project's mechanisms or parameter designs are flawed, it could lead to instability in the protocol's operation, potentially resulting in users facing large liquidations.

Overall, the risk lies in the design of fixed-rate protocols, which is a complex process that requires continuous trial and error.

Chain Catcher: You just mentioned that fixed-rate protocols linked to Aave/Compound carry higher risks. What do you think are Aave's greatest uncertainties and innovations?

Cai Yan: Aave has always been at the forefront of the industry, and their iteration speed is very fast. For example, they were the first to try flash loans, introduce new economic incentive models, and launch the industry's first security module, as well as explore L2 solutions, among other innovations.

In their main lending business, they are quite cautious. For instance, in the design of risk parameters like collateral ratios and liquidation coefficients, they are more conservative compared to other lending protocols, and they do not lower risk requirements to attract more lending funds.

Like many DeFi projects, even though Aave has undergone numerous audits, it cannot guarantee that there are no vulnerabilities. Recently, when Aave just launched V2, a white-hat hacker pointed out a certain vulnerability.

The innovation point may have been the flash loan, which was a unique new product feature in the industry at the time and brought Aave a lot of revenue. Of course, some criticize flash loans for maximizing capital efficiency for hackers, but the tool itself is not at fault. In the future, flash loans will definitely have more application scenarios.

Secondly, the design of the security module is akin to a reserve fund for the project to ensure its safety, which Aave pioneered. To be honest, most projects currently cannot establish a healthy or positively functioning token model, nor can they create a security module like Aave's, which is quite a barrier.

Chain Catcher: The mining model is, to some extent, the fundamental support for the wealth effect in DeFi. However, Aave's CEO previously stated that the mining mechanism cannot continuously provide momentum. What is your view on this?

Cai Yan: The "mining mechanism" is unlikely to become ineffective, as it serves as an incentive mechanism or a way for projects to kickstart. However, liquidity mining APY will not always remain high. For example, in November of last year, high APY liquidity mining lasted for a month or two before collapsing, leading to a significant correction in the DeFi market.

Projects like Aave, Uniswap, and Synthetix truly exploded into the top 15 by market cap around January and February of this year. I tend to view this as a reflection of the long-term value of leading DeFi. While everyone loves to chase high APY mining, I personally participate in mining very little, so I don't believe liquidity mining is the fundamental support of DeFi.

Chain Catcher: Similarly, as a lending protocol, MakerDAO may not have experienced the rapid growth of Aave, but its overall development has been stable. Recently, it has also periodically increased some underlying assets, expanding its asset richness. What potential risks do you think this expansion may bring?

Cai Yan: I think the market may be more critical of MakerDAO. Firstly, it is perceived as the central bank of DeFi, with DAI serving as the primary stablecoin in the DeFi system. Therefore, when it pushes some expansion strategies, the market may feel that Maker's innovation capacity has been exhausted, and it can only boost the token price without considering the system's stability.

Currently, there is no need to worry about these issues. As one of the oldest DeFi protocols, MakerDAO's development is still quite mature.

Chain Catcher: I agree. Previously, you shared your views on insurance protocols in the article on DeFi narratives & data. Considering recent developments, when do you think the insurance sector will reach its explosive point?

Cai Yan: Even in traditional finance, insurance is a very difficult product to manage. Firstly, insurance involves many participants, and the DeFi industry is even more so, especially with the recent frequent "hacker incidents." Therefore, it is challenging to compensate for every security incident, which also indicates that no project can be strong enough to provide very effective compensation to users.

So why can traditional insurance achieve this? Firstly, it is integrated into the larger financial framework. For example, traditional large commercial insurance companies continue to reinvest after being insured by a large number of users. Large insurance policies can also be reinsured, creating a stable system with substantial long-term cash flow to ensure business operations, and they generally do not go bankrupt due to large payouts.

Secondly, traditional insurance also has national fiscal support and backing, which does not exist in the DeFi industry. Thus, DeFi insurance can only create relatively innovative products to cover what it can, such as Cover, which operates on a user betting model to lead the market; Nexus Mutual's main idea is mutual insurance, which can better build a larger capital pool.

Recently, the popular insurance project Unslashed is a tiered risk insurance model. It has its own algorithm that scores projects and grades insurance based on that algorithm, first determining which projects are safer and which are relatively unsafe, and then designing policies based on risk coefficients to maximize the efficiency of user funds.

Chain Catcher: So who insures the insurance protocols?

Cai Yan: There is no way to solve this. The term "DeFi insurance" inherently refers to DeFi projects, which still carry potential risks of being hacked, stolen, or internal team issues. No one can guarantee insurance protocols.

Overall, the industry is quite disappointed with insurance. For instance, the CEO of Nexus had an incident where his wallet was stolen, and the mechanism itself is not conducive to the rise of its token price, making it quite awkward. Similarly, although Cover designed a decent mechanism, the team's poor performance has led to diminished confidence.

Chain Catcher: Nowadays, the composability between on-chain protocols is thriving and has seemingly become a trend. In this context, are there important issues in the DeFi market that have yet to be recognized?

Cai Yan: Composability does indeed exacerbate systemic risks in DeFi, but at the same time, composability is certainly beneficial for the development of DeFi, with benefits outweighing drawbacks. Everyone should look at the positive side. However, the issue that needs to be heeded is that the market is currently booming, and some products may adopt overly aggressive development strategies. For example, I am quite averse to the project Cream, which uses many highly volatile tokens as collateral assets.

Moreover, during a bear market, there were concerns about whether Synthetix's mechanism could lead to a spiral decline risk, as its smart contract design is very complex, and users can only generate synthetic assets by collateralizing tokens. At that time, many people were predicting various risks, but now that we are in a bull market, with most DeFi tokens having risen significantly, hardly anyone is discussing these potential concerns. The overheated market has led people to overlook small loopholes in mechanisms and potential risks.